Finance and Poverty: Evidence from India

Submitted by Thorsten Beck
On Mon, 06/17/2013

co-authors: Meghana Ayyagari, Mohammad Hoseini

The relationship between finance, inequality and poverty is a controversial one. While some observers attribute not only the crisis but also rising inequality in many Western countries to the rise of the financial system (e.g. Krugman, 2009), others see an important role of the financial sector on the poverty alleviation agenda (World Bank, 2008). But financial sector policies are not only controversial on the macro, but also micro-level. While increasing access to credit services through microfinance had for a long time a positive connotation, this has also been questioned after recent events in Andhra Pradesh, with critics charging that excessive interest rates hold the poor back in poverty. In recent work with Meghana Ayyagari and Mohammad Hoseini, we find strong evidence for financial sector deepening having contributed to the reduction of rural poverty rates across India by enabling more entrepreneurship in the rural areas and by enticing inter-state migration into the tertiary sector.

Cross-country evidence has linked financial development both to lower levels and faster reductions in income inequality and poverty rates (Beck, Demirguc-Kunt and Levine, 2007; Clarke, Xu and Zhou, 2006). As is often the case with cross-country work, endogeneity concerns are manifold, exacerbated by measurement problems inherent to survey-based inequality and poverty measures. In addition, cross-country comparisons face limitations in identifying the channel through which financial deepening helps reduce poverty rates. Researchers have therefore turned to country-level studies, which allow better to control for omitted variable and measurement biases. Richer data on the country level also allow for a better exploration of channels through which finance affects inequality and poverty.

India is close to an ideal testing ground to ask these questions given not only its large sub-national variation in socio-economic and institutional development, but also significant policy changes it has experienced over the sample period (Besley, Boswell and Esteve-Vollart, 2007). We use two of these policy changes as identification strategies in our work. Specifically, we follow Burgess and Pande (2005) and exploit the policy driven nature of rural bank branch expansion across Indian states as an instrument for branch penetration and thus financial breadth. According to the Indian Central Bank’s 1:4 licensing policy instituted between 1977 and 1990, commercial banks in India had to open four branches in rural unbanked locations for every branch opening in an already banked location. Thus between 1977 and 1990, rural bank branch expansion was higher in financially less developed states while after 1990, the reverse was true (financially developed states offered more profitable locations and so attracted more branches outside of the program), as illustrated by Figure 1.

As an instrument for financial depth, we use the cross-state variation of per-capita circulation of English-language newspapers in 1991 multiplied by a time trend to capture the differential impact of the media across time after liberalization in 1991. With the relatively free and independent press in India (Besley and Burgess, 2002), a more informed public is better able to compare different financial services, resulting in more transparency and a higher degree of competition leading to greater financial sector development. Figure 2 shows the differential development of Credit to SDP in states with English language newspaper penetration above and below the median.

Figure 2: Bank Credit and English newspaper circulation

Our main findings

Relating annual state-level variation in poverty to variation in financial development, we find strong evidence that financial depth, as measured by Credit to SDP, has a negative and significant impact on rural poverty in India over the period 1983-2005. On the other hand, we find no effect of financial depth on urban poverty rates. The effect of financial depth on rural poverty reduction is also economically meaningful. One within-state, within-year standard deviation in Credit to SDP explains 18 percent of demeaned variation in the Headcount and 30 percent of demeaned variation in the Poverty Gap over our sample period. We also find that over the time period 1983-2005, financial depth has a more significant impact on poverty reduction than financial outreach. Our measure of financial breadth, rural branches per capita, has a negative but insignificant effect on rural poverty over this period, though a strong and negative effect over the longer period of 1965 to 2005, which includes the complete period of the social banking policy.

The channels

The household data also allow us to dig deeper into the channels through which financial deepening affected poverty rates across rural India. First, we find evidence for the entrepreneurship channel, as the poverty-reducing impact of financial deepening falls primarily on self-employed in rural areas. Second, we find that financial sector development is associated with inter-state migration of workers towards financially more developed states. The migration induced by financial deepening is motivated by search for employment, suggesting that poorer population segments in rural areas migrated to urban areas. The rural primary and tertiary urban sectors benefitted most from this migration, consistent with evidence showing that the Indian growth experience has been led by the services sector rather than labor intensive manufacturing (Bosworth, Collins and Virmani, 2007)

This last finding is also consistent with the finding that it is specifically the increase in bank credit to the tertiary sector that accounts for financial deepening post-1991 and its poverty-reducing effect.

Conclusions

Our findings suggest that financial deepening can have important structural effects, including through structural reallocation and migration, with consequences for poverty reduction. Our findings also have important policy repercussions. The pro-poor effects of financial deepening do not necessarily come just through more inclusive financial systems, but can also come through more efficient and deeper financial systems. Critical, the poorest of the poor not only benefit from financial deepening by directly accessing financial services, but also through indirect structural effects of financial deepening. This is consistent with evidence from Thailand (Gine and Townsend, 2004) and for the U.S. (Beck, Levine and Levkov, 2010) who document important labor market and migration effects of financial liberalization and deepening.

Besley, T., R. Burgess, and B. Esteve-Volart (2007) “The Policy Origins of Poverty and Growth in India,” Chapter 3 in Delivering on the Promise of Pro-Poor Growth: Insights and Lessons from Country Experiences, edited with Timothy Besley and Louise J. Cord, Palgrave MacMillan for the World Bank.